Saving for retirement may be the last thing on your mind when you get your first job out of college, or when you are otherwise struggling to make ends meet. But the federal government offers a special income tax break that could dramatically reduce your after-tax cost.
One problem: This break is so buried in the complex tax code that many people miss it.
"Hardly any of the people who qualify for the credit are aware of it," said Catherine Collinson, president of the Transamerica Center for Retirement Research.
Collinson's organization surveyed thousands of individuals and found that only 12 percent of the respondents who earned less than $50,000 -- those most likely to qualify for the credit -- had heard of it. And just 17 percent of those who were aware of the credit had claimed it.
Of more than 7,000 people responding to the survey, only 18 reaped the rewards of this lucrative tax break, Collinson said.
"Every dollar counts in this economy," Collinson said. "It's important that people who can qualify for this credit have the information they need to claim it."
The retirement saver's credit can reimburse you for up to 50 percent of your retirement-plan contributions through a dollar-for-dollar reduction in the tax that you owe. But the credit is graduated, giving the most to those who have the least income. It doesn't help you if you pay no tax at all.
It's best for singles and married couples who don't have dependents and have few other deductions.
You qualify for the credit if you earn less than $27,500 when single, $55,500 when married, or $41,625 if you're the head of a household and contribute to a qualified retirement plan. Qualified plans include workplace plans, such as 401(k) and 403(b) accounts, individual retirement accounts and SEP-IRAs for the self-employed.
Here's an example of how the credit can work:
Consider a couple who earn $35,000 a year, rent an apartment and have no children or significant itemized deductions. If they didn't contribute to a retirement plan, they'd pay $1,633 in tax on $16,300 in taxable income. (Their taxable income is what's left after they subtract the standard deduction of $11,400 and two personal exemption credits of $3,650 each.)
But if they each contribute $1,000 to an individual retirement account, they'll trigger two tax breaks. One is simply the IRA deduction, which cuts their taxable income by the amount of their contribution. In this case, that would reduce the tax they pay by $200 to $1,433.
On top of that comes the retirement saver's credit.
To calculate the amount of this credit, the couple would fill out Form 8880. This asks them to multiply the amount of their IRA contributions by a percentage noted in the 8880 chart, which is organized by income. Their income after IRA contributions -- $33,000 -- qualifies them for a 50 percent credit, or $1,000. This credit is then subtracted from the tax they owe. That would further reduce their tax to $433 from $1,433.
The bottom line: Their $2,000 IRA contribution would save them $1,200 in federal income taxes.
Had this couple earned more, the credit would be less generous -- somewhere between 10 percent and 20 percent of what they had contributed. Still, because it reduces tax on a dollar-for-dollar basis, it would still be worthwhile. Even at 20 percent, the combination of the IRA deduction and the retirement saver's credit would reduce this couple's tax by $600.
What if you realize you could have qualified for this credit but failed to make a retirement contribution in 2010? There's still time. Taxpayers can contribute to an IRA or SEP-IRA until the tax deadline of April 15 and still qualify for both the IRA deduction and the retirement saver's credit, said Mark Luscombe, principal tax analyst with CCH Inc., a publisher of tax information.
But you say you can't afford to save for retirement on such a paltry income?
The good news is that the money doesn't necessarily have to come out of your wages. If you have generous relatives who want to give you holiday, birthday or wedding gifts, they can give you the cash to contribute. You get the tax break and a significant start on retirement saving in return.